staff paper april 2021 (ifrs 9)

The IFRS Interpretations Committee is the interpretative body of the International Accounting Standards Board (Board). The Board is the independent standard-setting body of the IFRS Foundation, a not-for-profit corporation promoting the adoption of IFRS Standards. For more information, visit www.ifrs.org..

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Agenda ref 4A

STAFF PAPER April 2021

IFRS® Interpretations Committee meeting

Project Hedging Variability in Cash Flows due to Real Interest Rates (IFRS 9)

Paper topic Comment letters

CONTACT Matthias Schueler

Riana Wiesner

[email protected]

[email protected]

+44 (0)20 7246 6410

+44 (0)20 7246 6412

This paper has been prepared for discussion at a public meeting of the IFRS Interpretations Committee (Committee) and does not represent the views of the International Accounting Standards Board (Board), the Committee or any individual member of the Board or the Committee. Comments on the application of IFRS Standards do not purport to set out acceptable or unacceptable application of IFRS Standards. Decisions by the Board are made in public and reported in IASB® Update. Decisions by the Committee are made in public and reported in IFRIC® Update.

Introduction

1. This paper reproduces comment letters on the IFRS Interpretations Committee’s

tentative agenda decision ‘Hedging Variability in Cash Flows due to Real Interest

Rates (IFRS 9)’ published in December 2020.

http://www.ifrs.org/

mailto:[email protected]


Deloitte Touche Tohmatsu Limited Hill House 1 Little New Street London

EC4A 3TR

Phone: +44 (0)20 7936 3000 Fax: +44 (0)20 7583 0112 www.deloitte.com/about

Direct phone: 020 7007 0884 [email protected]

Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee (“DTTL”), its network of member firms, and their related entities. DTTL and each of its member firms are legally separate and independent entities. DTTL (also referred to as “Deloitte Global”) does not provide services to clients. Please see www.deloitte.com/about for a more detailed description of DTTL and its member firms. Deloitte Touche Tohmatsu Limited is a private company limited by guarantee incorporated in England & Wales under company number 07271800, and its registered office is Hill House, 1 Little New Street, London, EC4a, 3TR, United Kingdom. © 2021 . For information, contact Deloitte Touche Tohmatsu Limited.

Dear Ms Lloyd

Tentative agenda decision – Hedging Variability in Cash Flows due to Real Interest Rates (IFRS 9 Financial Instruments)

Deloitte Touche Tohmatsu Limited is pleased to respond to the IFRS Interpretations Committee’s publication in the December 2020 IFRIC Update of the tentative decision not to take onto the Committee’s agenda the request for clarification on the application of hedge accounting requirements in IFRS 9 when the risk management objective is to ‘fix’ the cash flows in real terms.

We agree with the IFRS Interpretations Committee’s decision not to add this item onto its agenda. We have included in this letter some comments on the basis for reaching the conclusion in the decision.

The tentative agenda decision concludes that the rebuttable presumption in IFRS 9:B6.3.13, ‘that unless inflation risk is contractually specified, it is not separately identifiable and reliably measurable and hence cannot be designated as a risk component of a financial instrument’ has not been rebutted. We understand that this is based on the specific facts and circumstances presented in the original submission.

We would suggest that there is an additional rationale as to why the hedge relationship described in the decision cannot be eligible under IFRS 9 as a cash flow hedge, which could be included within the decision. This rationale is based on the fact that the ‘fixing’ of the cash flows illustrated in the submission is in real terms as opposed to nominal terms.

For a cash flow hedge of real rate risk to qualify for hedge accounting under IFRS 9, it is necessary for the cash flows to be fixed in nominal terms (in the currency of the debt of the functional currency of the entity). It is not appropriate for the economic relationship of the hedge to be assessed in real terms because reporting in real terms is not recognised under IFRS Standards. The financial statements are presented in nominal terms and therefore hedge effectiveness must also be assessed in nominal terms. Therefore, the hedge relationship described in the agenda decision will not be eligible because the cash flows are not fixed in nominal terms.

Furthermore, if assessing the effectiveness of a cash flow hedge in real terms were permitted, a swap of fixed rate debt cash flows for inflation-linked debt cash flows would, subject to rebutting the presumption in IFRS 9:B6.3.13 for fixed rate debt, reflect an eligible cash flow hedge because in real terms, the fixed rate debt is variable before the hedge but fixed after (i.e. the inflation-linked debt is fixed in real terms). However, for financial reporting purposes, which is in nominal terms, the swap would create significant

12 February 2021

Sue Lloyd Chair IFRS Interpretations Committee Columbus Building 7 Westferry Circus Canary Wharf London United Kingdom E14 4HD

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variability in profit or loss rather than reducing it because the debt cash flows are fixed before the hedge and variable after, which is inconsistent with the notion of a cash flow hedge.

If you have any questions concerning our comments, please contact Veronica Poole in London at +44 (0) 20 7007 0884.

Yours sincerely

Veronica Poole

Global IFRS Leader

KPMG IFRG Limited 15 Canada Square [email protected] London E14 5GL

United Kingdom

KPMG IFRG Limited, a UK company, limited by guarantee and a member firm of the KPMG global organisation of independent member firms affiliated with KPMG International Limited, a private English company limited by guarantee.

Registered in England No 5253019 Registered office: 15 Canada Square, London, E14 5GL

Ms Sue Lloyd International Accounting Standards Board Columbus Building 7 Westferry Circus London E14 4HD

12 February 2021

Our ref RD/288

Dear Ms Lloyd

Tentative Agenda Decision: Hedging Variability in Cash Flows Due to Real Interest Rate (IFRS 9)

We appreciate the opportunity to comment on the IFRS Interpretations Committee (Committee) tentative agenda decision Hedging Variability in Cash Flows Due to Real Interest Rate (IFRS 9). We have consulted with, and this letter represents the views of, the KPMG network. Overall, we do not support the Committee’s tentative agenda decision (‘TAD’). Our main observation is that we do not believe that the rationale for the conclusion is clearly based on existing requirements in the standards. We recommend that the Committee amend the TAD to provide an analysis that is more linked to existing requirements in IFRS 9. We believe that whether an inflation risk component, as well as a real interest rate risk component, is a separately identifiable and reliably measurable component depends on the market structure in any jurisdiction as described in IFRS 9.B6.3.13–15. Finally, we note that users may have different interpretations of what constitutes a “real rate”. We believe that a conclusion made with an analysis of what the entity actually designates in the hedging relationship and how it determines the change in cash flows of the real interest rate risk component being hedged would assist stakeholders in better understanding the decision and the associated reasoning. We set out below specific observations and comments: — IFRS 9.B6.3.13 states that “in limited cases, it is possible to identify a risk

component for inflation risk that is separately identifiable and reliably measurable because of the particular circumstances of the inflation environment and the relevant debt market”. IFRS 9.B6.3.14 gives an example that if a term structure of zero-coupon real interest rates can be constructed, an inflation risk component could be determined by discounting the cash flows of the hedged debt instrument


KPMG IFRG Limited Tentative Agenda Decision: Hedging Variability in Cash Flows Due to Real Interest Rate

(IFRS 9) 12 February 2021

RD/288 2

using the term structure of zero-coupon real interest rates. These two paragraphs suggest that in a market environment where a liquid real interest rate curve can be constructed, an inflation component can be a risk component which is separately identifiable and reliably measurable.

Given that the identification of a separately identifiable and reliably measurable inflation component depends on the ability to construct a real interest rate curve, it would appear counterintuitive to conclude that the real interest rate curve itself could not be a separately identifiable and reliably measurable component.

— The TAD contains the statement that “The real interest rate, and therefore the effect of inflation, is not a risk component that explicitly or implicitly influences the determination of a nominal benchmark interest rate”. It is unclear:

– how this statement stands together with IFRS 9.B6.3.13–14 where it states that inflation risk can be a separately identifiable and reliably measurable risk component. In particular, the statements made in IFRS 9.B6.3.13–14 do not include any explicit limitation to fair value hedges or the explicit exclusion of cash flow hedges. The arguments presented in those paragraphs are made in respect of the nature of the market. If it had been the Board’s intention to limit the ability of an entity in the designation of a non-contractually specified inflation component to only fair value hedges, we believe that it would have been made clear; and

– on what basis IFRIC makes this statement or would be able to make this statement. It appears to be a question of fact that is contingent on the behaviour of market participants and relevant facts and circumstances and thus might be true or not depending on those facts and circumstances. There appear to be divergent views among economists on this subject and some of them disagree with IFRIC’s apparent conclusion – e.g. a nominal interest rate may be influenced by expected inflation and an expected real interest rate1. Alternatively, the statement may be trying to explain some analytical or conceptual point regarding the meaning of the terms used but if so that point is not understandable to us. Furthermore, we note that this statement does not seem to be consistent with the assertion in IFRS 9.B6.3.14 that, in some circumstances, “inflation is a relevant factor that is separately considered by the debt markets”, implying that inflation is something that influences the determination of nominal benchmark interest rates.

1 For example, extracted from “Long Term Interest Rates”, 01/03/2013 – Speech by Ben Bernanke, Federal Reserve Chairman – “What monetary policy actually controls is nominal short-term rates. However, because inflation adjusts slowly, control of nominal short-term rates usually translates into control of real short-term rates over the short and medium term. In the longer term, real interest rates are determined primarily by nonmonetary factors, such as the expected return to capital investments, which in turn is closely related to the underlying strength of the economy.”

KPMG IFRG Limited Tentative Agenda Decision: Hedging Variability in Cash Flows Due to Real Interest Rate

(IFRS 9) 12 February 2021

RD/288 3

— It is unclear how the statement that “measurement and forecasts of actual inflation are based on statistical methodologies and therefore entail a time lag” is relevant in analysing the fact pattern. If it is relevant and this can be clarified, it would also be necessary to clarify why this would not be a factor in preventing an inflation rate from being separately identifiable in the example given in IFRS 9.B6.3.14.

— The TAD states that “to meet the requirements in IFRS 9 for a cash flow hedge designation, the variability of individual cash flow streams attributed to the designated risk component needs to be separately identifiable in currency or nominal terms.” IFRS 9 discusses the requirements for cash flow hedge eligibility principally at IFRS 9.6.3.7(a) and IFRS 9.6.5.2(b). There appears to be no such specific requirement that a cash flow hedged item needs to be separately identifiable in currency or nominal terms. IFRS 9.B6.3.7 states that “a component is a hedged item that is less than the entire item” and “reflects only some of the risks of the item of which it is a part or reflects the risks only to some extent”. IFRS 9.B6.3.8 states only that “a risk component must be a separately identifiable component of the … item, and the changes in the cash flows … of the item attributable to changes in that risk component must be reliably measurable”.

Please contact Reinhard Dotzlaw at [email protected] or Chris Spall at [email protected] if you wish to discuss any of the issues raised in this letter.

Yours sincerely

KPMG IFRG Limited



ASSOCIATION OF NATIONAL ACCOUNTANTS OF NIGERIA

Comments on the Tentative Agenda Decision and comment letter on Hedging

Variability in Cash Flows due to Real Interest Rate (IFRS 9)

The Association of National Accountants of Nigeria (ANAN) has critically and painstakingly

reviewed the basis of IFRS Interpretations Committee’s decision and welcomes the opportunity to

comment on the Tentative Agenda Decision and comment letters: hedging variability in cash flows

due to real interest rate (IFRS 9).

The basic issue dealt with by the IFRS Interpretations Committee in the tentative agenda decision

and comment letter on hedging revolves around the question of whether a non-contractually

specified interest risk component can be designated as hedged item in a cash flow hedging

relationship. The Committee dealt with this question under two perspectives.

First is whether the floating rate instrument described in the fact pattern has exposure to variability

in cash flows that are attributable to real interest risk components as required in paragraph 6.5.2

(b) of IFRS 9.

The Association agrees with the Committee’s conclusion that the requirement in IFRS 9 provides

an adequate basis to determine whether a hedge of the variability in cash flows arising from

changes in the real interest rate, rather than the normal interest rate, could be accounted for as cash

flow hedge.

The second perspective is whether the real component interest risk component described in the

fact pattern is separately identifiable and reliably measurable as required by paragraph 6.3.7 of

IFRS 9.

In relation to this question, the Association agrees with Committee’s conclusion that changes in

cash flows as a floating instrument arising from the real interest rate risk component cannot be

identified independently of changes in cash flows arising from other risk components. To this end,

it cannot be reliably measured as required by paragraph 6.3.7 of IFRS 9.

For any further information or clarification, please contact the undersigned.

Dr. Nuruddeen Abba Abdullahi, mni, FCNA

Chief Executive Officer

Association of National Accountants of Nigeria

[email protected]

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Classification: Public

Hedging Variability in Cash Flows Due to Changes in Real Interest

Rates (IFRS 9)

Response to Tentative Agenda Decision

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Contents

1. Executive Summary .................................................................................................................................... 3

2. Market Structure ........................................................................................................................................ 4

3. Application of IFRS 9 ................................................................................................................................... 7

Risk Management Objective ............................................................................................................. 7

Separately Identifiable and Measurable ........................................................................................... 8

Alternative Hedge Accounting Designations .................................................................................... 8

3.3.1 Cash Flow Hedge Accounting for Revenue ........................................................................................ 8

3.3.2 Fair value hedge of the inflation component in fixed rate debt ........................................................ 9

Cash Flow Hedge Accounting - Hedging Variability in Cash Flows Due to Real Interest Rate ........... 9

4. Appendices ............................................................................................................................................... 12

Current Outstanding Gilts ............................................................................................................... 12

LCH Clearing Volumes ..................................................................................................................... 14

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1. Executive Summary

International Financial Reporting Standards (“IFRS”) are designed to provide investors a better, more consistent sense of risk and return when reading a set of financial statements. Without certainty in whether IFRS 9 hedge accounting can be applied to inflation1 swaps used by companies for valid risk management purposes, investors will continue to face material variances between what is being presented in the financial statements and the risk management activities of regulated companies in which they invest i.e. the current accounting is giving users a false sense of risk within the financial statements, even though the risk management activity is minimising long term financial risk. This variance is being generated by a narrow interpretation of the letter of the standard rather than considering the underlying principles and objectives of IFRS 9 to more closely align to risk management. To emphasize the importance of this response, participants including regulated entities, listed entities and investors (collectively referred to as “the Group”) have jointly submitted this paper. The Group includes:

Heathrow Airport Limited National Grid plc Northumbrian Water Ltd

Northern Gas Networks Anglian Water Group Limited UK Power Networks

Yorkshire Water Services Limited TCI Advisory Services LLP

This paper aims to provide the committee further background and rationale for the economic risk management strategy and ultimately the validity of the hedge designation, including outlining why real rates are a separately identifiable component in the UK. By permitting this designation the quality and consistency of financial reporting is improved, with the reduced need for diverse reporting methods and application of reporting compromises to support explanation of fair value movements related to these instruments. The paper outlines why this designation is applicable by outlining:

1. The market structure for inflation in the UK 2. Why real rates are separately identifiable and reliably measurable 3. The risk management objective 4. Alternate hedge accounting designations not discussed in the original submission 5. Specific thoughts on the Tentative Agenda Decision (“TAD”)

In summary, we believe that guidance contained within IFRS 9 allows this designation, thus, are requesting IFRIC re-consider the TAD. The Group acknowledges the complexity of the subject; hence, would welcome the opportunity to further discuss this with IFRIC staff before the TAD is finalized. Please contact Nick Golding, Finance Director, Heathrow Airport Limited on [email protected] for further communication in regards to this paper.

1 For the purposes of this analysis, the only relevant measure of inflation is Retail Price Index (“RPI”)


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2. Market Structure

Summary

• The total size and liquidity of the market in GBP Nominal and Inflation bonds is significant.

• The existence and measurability of the nominal, inflation and real yield curve is well-established, both

in gilts and swaps.

Overview of UK market

The inflation-indexed bond market in the UK is well-established. The UK government issued the first inflation-

indexed Gilt (“Index-Linked Gilts”) in 1981. Index-Linked Gilts are linked to the General Index of Retail Prices

in the UK (“RPI”), one of the main measures of inflation in the UK. The DMO has continued frequent issuance

of Index-Linked Gilts in size, issuing more than £25bn of Index-Linked Gilts every year since 2009. Currently, of

the c. £1.9tn of Gilts outstanding, 24% are linked to RPI. See below a table of all the current Gilts outstanding

split by maturity and nominal vs. inflation.

Table: Current Outstanding Gilts

Maturity (years) x<4 4≤x<7 7≤x<15 15≤x<30 30≤x Total

Total (£bn) 277 422 408 539 283 1,927

o/w Nominal Gilt 92% 82% 75% 69% 68% 76%

o/w Index-Linked Gilt 8% 18% 25% 31% 32% 24%

Due to the large volume of outstanding Gilts (Nominal and Index-Linked) with various maturities, accurate

prices can readily be obtained and used to construct zero coupon curves (using interpolation between bonds

maturities). See Appendix 1 for list if outstanding bonds.

A nominal yield curve can be derived from the Nominal Gilts, and notably a real yield curve can be derived

from outstanding Index-Linked Gilts2.

2 Constructing a zero-coupon curve from bond pricing across maturities can be done via the “bootstrapping” method

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Chart: Real Yield Curve derived from Index-Linked Gilts

Source: Bloomberg as at 14-Nov-18

Following the construction of a reliably measurable zero coupon nominal and real yield curves from the Gilt

market, a zero coupon breakeven inflation curve arises by definition, as the breakeven inflation is the implied

rate differential between the real rate curve and the nominal curve. I.e., the breakeven inflation rate is the

rate representing the erosion of pricing power, which is the difference between the nominal and real rates.

The existence and measurability of the nominal, inflation and real yield curve is well-established; the Bank of

England (“BoE”) publishes these curves on a daily basis (see charts below).

Chart: Bank of England Daily Published Nominal, Real Yield and Inflation Curves

UK instantaneous nominal forward curve (gilts) UK instantaneous implied real forward curve (gilts)

(2.25)

(2.00)

(1.75)

(1.50)

(1.25)

(1.00)

0.0 5.0 10.0 15.0 20.0 25.0 30.0 35.0 40.0 45.0 50.0

Yie

ld t

o M

atu

rity

(%

)

Years to Maturity

Mid YTM

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UK instantaneous implied inflation forward curve

(gilts)

Source: https://www.bankofengland.co.uk/statistics/yield-curves. Please also see

https://www.bankofengland.co.uk/statistics/yield-curves/terminology-and-concepts for a more in-depth

explanation of how these curves are constructed.

Fisher Equation

The UK market is an example of a market where the Fisher equation can be directly observed i.e. the pricing

of nominal and inflation linked gilts by definition allow market participants to observe and trade the three

components (nominal, real and breakeven inflation rates). Given the deep liquidity of the bond markets there

is no arbitrage between the two such that either of the following can be observed to be true

Nominal rate – Real rate = Inflation breakeven in a given tenor

Nominal rate – Inflation breakeven = Real rate in a given tenor

The BoE notes the following:

“We have seen that the index-linked gilt market allows us to obtain real interest rates and the conventional

gilt market allows us to obtain nominal interest rates. These nominal rates embody the real interest rate plus

a compensation for the erosion of the purchasing power of this investment by inflation. The Bank uses this

decomposition (commonly known as the Fisher relationship) and the real and nominal yield curves to calculate

the implied inflation rate factored in to nominal interest rates.”

The above is all derived from the Gilt market. However, nominal, inflation and real rates are also traded in

swap format. In the paragraph below we show that the swap market is also sufficiently liquid and readily

observable.

We note that IFRS 9 does not allow the inflation / real component to be identified using the swap market, the

below analysis is additive to the Gilt market analysis above and is important as it demonstrates how investors

view the inflation market.

https://www.bankofengland.co.uk/statistics/yield-curves

https://www.bankofengland.co.uk/statistics/yield-curves/terminology-and-concepts

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Inflation Swap Market

In the UK swaps market nominal, real and breakeven rates can be traded independently and each component

is considered liquid and observable with quotes available for every day. The definitions below explain these

instruments in terms of cash flows. We have also included a diagram in the appendix.

• Nominal Swap: set of cash flows equal to exchanging Fixed Bond vs a Floating Bond

• Inflation Swap (or Breakeven Swap): set of cash flows equal to exchanging an Inflation Bond vs a Fixed Bond

• Real Yield Swap: set of cash flows equal to exchanging an Inflation Bond vs a Floating Bond. Hence, a Real Yield Swap can be derived directly from a Nominal Swap and an Inflation Swap.

Nominal Swaps and Inflation Swaps in GBP are very liquid and trade in large volume. See Appendix 2 for LCH

Clearing Volumes. GBP interest rate swap (Nominal Swaps) volumes are in excess of £10tn, whereas Inflation

Swap volumes are in excess of £1.5tn. As a Real Yield Swap is simply the combination of a Nominal Swap and

an Inflation Swap (as per the definitions above), its price and liquidity are of similar magnitude. In addition to

the cleared market as indicated in the LCH Clearing Volumes referenced, there exists a bilateral swaps market.

A broad estimate would put approximately 40% of total volumes in such swaps as cleared and the remainder

would be bilateral. Thus, the total size of the market in GBP Nominal and Inflation swaps is significant.

3. Application of IFRS 9

Summary

• Prudent risk management and market pricing drive the need to raise inflation-linked debt instruments.

• There is sufficient liquidity in the markets for both inflation and real rates to be considered a separately

identifiable and measurable components.

• Payments are not necessarily nominal and there is no evidence in IFRS literature.

• Cash flow hedge designation in real terms meets the criteria of IFRS9.

• Real rates are not the residual factor but a separately identifiable and reliably measurable component.

Risk Management Objective

Regulated clients have a revenue model which is based on a percentage of the Regulatory Asset Base

(“RAB”). This is determined by the respective regulator for each industry and is based on funding provided

by respective government agencies which is also funded by inflation linked debt (e.g. UK Gov RPI bonds). By

linking their debt payments and borrowings to inflation these regulated entities can ensure that as their

revenue and value of regulated assets fluctuate for changes in inflation rates, so too will their debt payments

and borrowings. Should a regulated entity not link a portion of their debt to inflation then they are at risk of

a mismatch between their income streams and their debt obligations.

Where possible, funding requirements for these businesses will be met by issuing index linked Index bonds. However, many entities usually achieve this by issuing nominal fixed / floating rate debt and subsequently swapping the cash flows into inflation linked cash flows in order to synthetically create inflation linked debt. The combination of issuing a nominal bond and an inflation swap is often preferable to issuers as it allows them to obtain the best credit spread pricing (without limiting themselves to only investors interested in

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inflation) as well as the best inflation pricing. This leaves corporates with the choice of more expensive debt or nonsensical volatility reporting.

Fundamentally holding inflation linked debt instruments clearly provides a valid economic offset. The current status quo whereby the issuance of a inflation bond and the issuance of a nominal bond plus and inflation swap which combine to give exactly the same end cashflows but produce materially different results in the reporting of annual performance is not beneficial for users of accounts and undermines the value of hedge accounting in such businesses as all volatility is often then disregarded for meaningful reporting.

Assuming that the nominal fixed rate issued on a debt instrument is made up of the day 1 values of expected credit, inflation and real rates for the relevant tenor, by entering into the inflation swap, the entity has protected itself against fair value changes in the inflation component of the fixed rate debt while retaining fair value exposure to the fixed real rate component.

RAB is not a valid hedged item as it is not recognised on the balance sheet.

In many cases it has also been difficult to achieve hedge accounting for the inflation component of revenue,

see Section 3.3.1 below.

Separately Identifiable and Measurable

Rebutting the presumption that inflation is not separately identifiable and reliably measurable.

IFRS 9:B6.3.13 states that:

“There is a rebuttable presumption that unless inflation risk is contractually specified, it is not separately

identifiable and reliably measurable and hence cannot be designated as a risk component of a financial

instrument. However, in limited cases, it is possible to identify a risk component for inflation risk that is

separately identifiable and reliably measurable because of the particular circumstances of the inflation

environment and the relevant debt market.”

As discussed in Section 2, based on the UK market structure, it is accepted that there is sufficient liquidity /

depth in the inflation bond markets for inflation to be considered a separately identifiable and measurable

component.

The analysis in Section 2 shows that real rates are separately identifiable and measurable. Real rates are not

the residual component as they are recognised as being the rate that an investor requires as compensation

to invest in inflation instruments. The real rate component is priced individually by bond issuance (similar for

swap pricing) depending on market conditions at a point in time.

Therefore, it is concluded that both inflation and real rates are considered separately identifiable and

measurable for the UK market.

Alternative Hedge Accounting Designations

3.3.1 Cash Flow Hedge Accounting for Revenue

As mentioned in the original submission to IFRIC, for regulated entities revenue is inflation linked. However,

as is often the case, while inflation is specified as part of a regulators published revenue mechanism for

these businesses, it is not a directly related to the overall allowed revenue and therefore in many cases

cannot be designated in a hedge accounting relationship. The reason that revenue cannot be designated as

the hedged risk is that revenue is determined by the regulated asset base of each entity and inflation is a

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component of determining the regulated asset value which is not reflected in IFRS accounting. Hence the

relationship of revenue to inflation, although real, is indirect.

There are limited circumstances where a cash flow hedge for the inflation component in revenue is eligible

for hedge accounting.

3.3.2 Fair value hedge of the inflation component in fixed rate debt

The IFRIC Agenda paper AP06 refers to IFRS 9 B6.3.14 in relation to how fair value hedge accounting has been contemplated as an eligible designation. The hedged risk in this designation is the variability in the fair value of the identified debt payments, attributable to changes in inflation. The inflation component of the coupon is designated at inception of the hedge. The hedged item can be discounted using a range of different curve constructions in order to isolate the inflation component. All examples arrive at a similar result as they are just varying representations of similar / the same market inputs. Each designation has been modelled, with all hedges showing volatility in with some same way movements between the hedged item and hedging instrument. The analysis shows that if the hedged fixed rate debt is adjusted only for changes in inflation a significant P/L mismatch from the fair value change of the inflation swap due to changes in real rates i.e. the cash flows of the swap have been fixed in real terms. The fair value of the inflation pay leg is driven by the fair value due to the retained fixed real rate i.e. it does

not reset to par. For example, an increase in inflation will result in an increase in the cash flows payable on

the derivative. These cash flows are subsequently discounted at LIBOR, comprising of inflation and real rates.

Variable inflation cash flows discounted by inflation results in no fair value movements. The remaining

impact is due to fixed real rates discounted at current real rates.

The mechanics and current market practice of fair value hedge accounting means that this designation will inevitably result in high levels of ineffectiveness due to the volatility in real rate changes being greater than the volatility of inflation change. The entity has retained the real rate fair value risk but exposed itself to fair value accounting, the ineffectiveness truly reflects the risk management activities of the company. For this designation to work, the mechanics of fair value hedge accounting would be required to be amended in order to allow the fair value change in real rates to be included in the fair value hedge adjustment. We are happy to share our analysis with the Staff.

Cash Flow Hedge Accounting - Hedging Variability in Cash Flows Due to Real Interest Rate

We believe that the key points in the TAD can be summarised as:

1. ‘Cash is by nature a nominal denomination in a respective currency’

2. For cash flow hedge accounting, cash flows can only be fixed in nominal terms

3. A real rate index / parameter does not exist but is a residual of the LIBOR and inflation curves

Each point is discussed below.

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‘Cash is by nature a nominal denomination in a respective currency’

There is an assertion that cash is by nature nominal, an assertion that is not found in IFRS literature. The

paper concludes that all payments on the swap are nominal payments and not payments linked to real rates.

The paper further explains that all cash payments on inflation linked bonds (and all other variable financial

instruments) are nominal payments and not inflation payments.

This differs to how corporates, investors and other institutions view the rationale for holding such

investments, as the return is fixed in real terms and not nominal terms. The parties would believe that cash

flows have been fixed in real terms.

For cash flow hedge accounting, cash flows can only be fixed in nominal terms

‘The Committee observed that, to meet the requirements in IFRS 9 for a cash flow hedge designation, the

variability of individual cash flow streams attributed to the designated risk component needs to be separately

identifiable in currency or nominal terms.’

Therefore, a cash flow hedge for variability in real rates is not an eligible hedge accounting relationship, even

if real rates can be shown to be separately identifiable.

The above interpretation is not outlined in IFRS 9, including in the definition of cash flow hedge accounting.

IFRS has previously permitted designating non-contractually specified risk components which can be shown

to separately identifiable and reliably measurable.

The cash flow hedge designation achieves the objective that it intended to i.e. reduce volatility in real terms.

Cash flow hedge accounting has not been viewed in nominal terms but with the criteria that it reduces

variability in cash flows. Therefore, we believe the proposed cash flow hedge designation meets the criteria

of paragraph 6.5.2 of IFRS 9.

A real rate index / parameter does not exist but is a residual of the LIBOR and inflation curves

The TAD states that ‘In addition, the Committee considered that, in the proposed cash flow hedging

relationship, the real interest rate would be an implied residual risk component (after combining the variable

inflation-linked cash flows and the floating benchmark rate-based cash flows). The Committee therefore

concluded that changes in cash flows on a floating rate instrument arising from the real interest rate risk

component cannot be identified independently of changes in cash flows arising from other risk components.

Consequently, the real interest rate risk component does not meet the requirements in paragraph 6.3.7 of

IFRS 9 to be designated as a risk component. It therefore is not an eligible hedged item as required by

paragraph 6.4.1 of IFRS 9.’

The analysis in Section 2 proves that real rates are not the residual factor but a separately identifiable and

reliably measurable component.

An additional data point is the routine use of inflation in pensions, pay arrangements and regulated

agreements that often reference a real rate, showing that real rates are not the residual component.

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4. Summary

In summary we believe that the proposed designation in the submission meets the criteria as outlined in

IFRS 9. Allowing this designation would allow the risk management objectives of the company to be aligned

with the accounting and provide more insight for the users of the financial statements.

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5. Appendices

Current Outstanding Gilts

Nominal Gilts £m Notional

8% Treasury Stock 2021 24,594

3¾% Treasury Gilt 2021 29,001

4% Treasury Gilt 2022 38,771

0½% Treasury Gilt 2022 29,260


0 1/8% Treasury Gilt 2023 33,824


2¼% Treasury Gilt 2023 35,265

0 1/8% Treasury Gilt 2024 18,371




0 5/8% Treasury Gilt 2025 41,356


0 1/8% Treasury Gilt 2026 30,895




0 1/8% Treasury Gilt 2028 26,730

1 5/8% Treasury Gilt 2028 36,332


0 7/8% Treasury Gilt 2029 41,865

0 3/8% Treasury Gilt 2030 37,339



4¼% Treasury Stock 2032 38,709


0 5/8% Treasury Gilt 2035 19,079

4¼% Treasury Stock 2036 30,408


4¾% Treasury Stock 2038 25,748



1¼ % Treasury Gilt 2041 24,831




7/8 Treasury 2046 6,500





0 5/8% Treasury Gilt 2050 28,133


1 5/8% Treasury Gilt 2054 21,960




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1 5/8% Treasury Gilt 2071 15,206

Source: DMO website as of 28-Jan-2021

Index-linked Gilts £m Notional (Including Index-Linked Uplift)

1 7/8% Index-linked Treasury Gilt 2022 22,473

2½% Index-linked Treasury Stock 2024 20,407



1¼% Index-linked Treasury Gilt 2027 21,436



4 1/8% Index-linked Treasury Stock 2030 10,471


0¾% Index-linked Treasury Gilt 2034 18,419

2% Index-linked Treasury Stock 2035 15,290








0¾% Index-linked Treasury Gilt 2047 16,513


0½% Index-linked Treasury Gilt 2050 16,813



0 1/8% Index-Linked Treasury Gilt 2056 7,137





Source: DMO website as of 28-Jan-2021

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LCH Clearing Volumes (as at 12 November 2018)

Source: LCH

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF NIGERIA (Established by Act of Parliament No. 15 of 1965)

Registrar/Chief Executive AHMED M. KUMSHE (PROF.), FCA

February 8th, 2021. ICAN/CP/R&T/FEB8/2020 IFRS Foundation Columbus Building 7 Westferry Circus Canary Wharf London E14 4HD. Dear Sir,

Re: Hedging Variability in Cash Flows Due to Real Interest Rate (IFRS 9)

Please find below our comments on the above-named Tentative Agenda Decision. Conclusion: The Committee concluded that the requirements in IFRS 9 provide an adequate basis for an entity to determine whether a hedge of the variability in cash flows arising from changes in the real interest rate, rather than the nominal interest rate, could be accounted for as a cash flow hedge. Consequently, the Committee [decided] not to add a standard-setting project to the work plan.

Response: We agree with the Committee’s conclusion that the principle and requirements in IFRS Standards provide an adequate basis for an entity to determine whether a hedge of the variability in cash flows arising from changes in the real interest rate, rather than the nominal interest rate, could be accounted for as a cash flow hedge. We will appreciate it if the Committee provides clarifications or an illustrative example, of circumstances where real interest rate can be designated as a hedged item. We thank you for giving us the opportunity to contribute to the Agenda Decision and we are available should there be need for further clarification. Yours faithfully,

For: Ahmed M. Kumshe (Prof.), FCA Registrar/Chief Executive

PLOT 16, IDOWU TAYLOR STREET, VICTORIA ISLAND, P.O BOX1580, MARINA, LAGOS, NIGERIA

Tel: 09053847510-1

Email: [email protected], [email protected]

Website: www.icanig.org


http://www.icanig.org/

Ernst & Young Global Limited is a company limited by guarantee registered in England and Wales No. 4328808.

Ernst & Young Global Limited 6 More London Place London SE1 2DA

Tel: +44 [0]20 7980 0000 Fax: +44 [0]20 7980 0275 ey.com

International Accounting Standards Board 7 Westferry Circus Canary Wharf London E14 4HD

15 February 2021

Dear Interpretations Committee, Invitation to comment – Hedging Variability in Cash Flows Due to Real Interest Rate (IFRS 9) Ernst & Young Global Limited, the central coordinating entity of the global EY organisation, welcomes the opportunity to offer its views on the above Tentative Agenda Decision (“TAD”) of the IFRS Interpretations Committee (‘Committee’) published in the December 2020 IFRIC Update. We appreciate the Committee addressing this question. The fact pattern outlined in the submission is common in the United Kingdom (“UK”), which has one of the most established inflation-linked government bond markets, and hence has been considered as one of the rare environments where the criteria outlined in paragraph B6.3.13 of IFRS 9 could be met. Our chief concern is that three key assertions are made in the TAD which conflict with our understanding of the UK inflation market or would appear to be interpretations of the standard, rather than being apparent from its words. These are discussed below, along with other points that we would like to bring to the Committee’s attention. Prior to discussing the assertions, we believe it is useful to outline briefly our understanding of the UK inflation market and the use of inflation-linked derivatives by certain regulated UK companies. ► We believe that there is sufficient liquidity in the UK inflation-linked government bond market to overcome the

rebuttable presumption in B6.3.13 of IFRS 9 and that, consequentially, inflation1 is a separately identifiable component of interest rates in the UK.

► Revenue for many regulated UK entities is inflation-linked. However, revenue is generally determined according to the regulated asset base, which is adjusted for inflation so, as the asset value changes, the revenue generated from those assets also changes. In these cases, inflation is only indirectly contractually specified and, thus, is not considered to be a separately identifiable component of the revenue.

► While the entity could achieve a natural hedge by issuing inflation-linked bonds, the market to issue inflation-linked corporate bonds is not very liquid. This is in contrast to the UK market for inflation-linked government bonds, which is highly liquid.

► Consequently it is common practice for many regulated companies to enter into inflation-linked derivatives to manage their exposure to inflation in their revenue, but to seek to designate the derivatives as a hedge of the real rate of floating rate bonds, so as to reflect their risk management practices in their accounting treatment.

1 The measure of inflation in the UK is currently the Retail Price Index (“RPI”)

2

The above helps set out the context for our concerns as discussed below. The TAD sets out three key assertions:

1. “Measurement and forecasts of actual inflation are based on statistical methodologies and therefore entail a time lag. The real interest rate, and therefore the effect of inflation, is not a risk component that explicitly or implicitly influences the determination of a nominal benchmark interest rate. There is therefore no identifiable variability in the benchmark rate-based nominal cash flows (for example, LIBOR cash flows) on a floating rate financial instrument that is attributable to the real interest rate risk component as required by paragraph 6.5.2(b) of IFRS 9.

2. “…in the proposed cash flow hedging relationship, the real interest rate would be an implied residual risk component (after combining the variable inflation-linked cash flows and the floating benchmark rate-based cash flows). The Committee therefore concluded that changes in cash flows on a floating rate instrument arising from the real interest rate risk component cannot be identified independently of changes in cash flows arising from other risk components”.

3. “…to meet the requirements in IFRS 9 for a cash flow hedge designation, the variability of individual cash flow streams attributed to the designated risk component needs to be separately identifiable in currency or nominal terms.

Taking each of these assertions in turn:

1. B6.3.13 of IFRS 9 states that, in limited cases, the presumption that inflation risk is not separately identifiable, can be rebutted, because of the particular circumstances of the environment and the relevant debt market. B6.3.14 goes on to say that in an environment in which inflation-linked bonds have a volume and term structure that results in a sufficiently liquid market, a term structure of zero-coupon real rates can be constructed, from which the inflation risk component can also be determined. This implies that, in such an environment, zero-coupon real rates as well as inflation risk would be separately identifiable.

3

The assertion in the TAD would appear to conflict with paragraph B6.3.14 of IFRS 9. If the Committee believes that real rates and inflation do not influence the determination of nominal rates, then this would appear to question the validity of B6.3.14. Furthermore, this assertion disputes the validity of the Fisher2 equation, which specifies the relationship between nominal, inflation and real rates and which underpins the issuance and use of inflation-linked bonds.

Given that the UK is an environment in which inflation-linked government bonds have a volume and term structure that results in a liquid market that allows zero-coupon real rates to be constructed3, it follows that real rates are generally considered a separately identifiable component of nominal UK government bond interest rates.

As inflation-linked bonds are actively traded both at inception and on secondary markets, the yield on these instruments is repriced by the market on a real-time basis. The yield on an inflation linked bond is determined by the buyers’ and sellers’ expectations of real rates over the remaining or issued tenor in the same way as a nominal bond’s yield is calculated. Hence, inflation-linked bonds are priced on a forward-looking basis, projecting future cash flows, rather than on historical data; i.e., there is no time lag involved, as asserted in the TAD.

Importantly, the real rate designated in the hedging relationship can be derived from inflation-linked bond prices. I.e., just as a zero-coupon nominal curve is derived via bootstrapping yields on a set of traded fixed nominal rate instruments, a zero-coupon real rate curve is derived via bootstrapping yields (the fixed real rate spread which drives the fair value of the inflation-linked bond) on a set of traded inflation-linked bonds. Hence, it meets the requirements of paragraph B6.3.14.

The above analysis is corroborated by the Bank of England, who note:

Implied inflation rates

We have seen that the index-linked gilt market allows us to obtain real interest rates and the conventional gilt market allows us to obtain nominal interest rates. These nominal rates embody the real interest rate plus a compensation for the erosion of the purchasing power of this investment by inflation. The Bank uses this decomposition (commonly known as the Fisher relationship) and the real and nominal yield curves to calculate the implied inflation rate factored into nominal interest rates.4

2. The TAD’S assertion, that it is not possible to identify separately a residual component, is presumably based on the discussion in BC 6.469-517 on the eligibility of credit risk as a risk component that can be hedged. The concern of the Board there was that the spread between the risk-free rate and the market interest rate incorporates credit risk, liquidity risk, funding risk and other unidentified risk component and margin elements, making it impossible to isolate just credit risk. In contrast, as already discussed above,

2 As defined in the initial submission 3 While corporate bond prices vary for changes due to a number of factors, such as credit risk and liquidity, in the context of liquid and highly rated inflation-linked government bonds, such as those issued by the UK Government, bond prices at issuance and subsequent trading are driven primarily based on macroeconomic factors, as is the case with nominal Government issued debt in the UK. Government issued nominal bonds, are routinely used to derive risk-free zero-coupon rates. 4 Source: Yield curve terminology and concepts | Bank of England

https://www.bankofengland.co.uk/statistics/yield-curves/terminology-and-concepts

4

while nominal and real rates are indeed inter-related, as two elements of the Fisher equation, they can both be separately identified. As mentioned above, real rates are not an implied residual component but a component of nominal rates that can be independently calculated from inflation-linked government bond issuances. The difference between the zero-coupon nominal curve and the zero-coupon real rate curve is the implied forward inflation curve, i.e., the market’s measure of future inflation. Therefore, one could argue that in the context of zero-coupon rates, if either component is the residual, it is inflation rather than the real rate.

Also relevant in the Standard is the requirement of paragraph B6.3.14 of IFRS 9, that “the entity cannot simply impute the terms and conditions of the actual hedging instrument by projecting its terms and conditions onto the nominal interest rate debt”. In this fact pattern, since the zero-coupon real rate curve is identified separately from inflation-linked bonds, rather than the hedging instrument, the requirement of B6.3.14 is met.

3. The assertion that ‘the variability of individual cash flow streams attributed to the designated risk component needs to be separately identifiable in currency or nominal terms’ would appear to be an interpretation, since this requirement is not expressed in the Standard. This is not surprising, since, prior to the possibility of hedging for inflation risk, the issue has never been relevant.

According to 6.5.2, a cash flow hedge is “a hedge of exposure to variability in cash flows attributable to a particular risk”. While a cash flow will always be a nominal amount, there is no requirement that a portion of the cash flow is fixed in nominal terms.

However, for this particular fact pattern, we do not believe that the assertion is relevant as the real rate component has been fixed in nominal terms. The effect of a cash flow hedge of the real rate component of the overall nominal rate of interest cash flow, is that the exposure to variability is reduced, since it will no longer vary with changes in the designated risk component (the real rate), but only with changes in inflation.

As the inflation-linked bond market demonstrates, the components of a nominal rate cash flow can be settled in their individual component parts, hence even though the real rate component has been fixed, all payments are expressed in nominal terms. Further, the reduction in variability of future nominal cash flows provided by a cash flow hedge can be expressed and measured in nominal terms.

We believe that the fact pattern supporting cash flow hedge accounting of the real rate component of variable rate debt outlined in the submission meets the requirements of paragraph 6.5.2. of IFRS 9.

Finally, paragraph B6.3.14 implies that it may be possible to designate a fair value hedge of the inflation component of a fixed rate bond. We have carried out substantial analysis and we believe that such a hedge may never meet the requirements of the Standard. The main reason for this is that the dominant fair value driver on inflation-linked bonds and swaps is the fair value changes due to the fixed real rates, rather than floating inflation5. We would be happy to discuss this further with the Committee. Consequently, if hedge accounting is not considered

5 The fair value of the inflation pay leg of the derivative is driven by the fair value changes due to the fixed real rate, i.e., unlike fair value hedges of LIBOR, where the present value of floating rate LIBOR debt remains constant if discounted with the zero coupon LIBOR. As the real rate has been fixed, the present value of cash flows discounted using a zero-coupon inflation curve cannot remain constant. As the fair value of the pay leg does not stay constant, the change in fair value of the hedging instrument does not necessarily move in line with the hedged item.

5

possible for the fact pattern set out in the submission, then it is unlikely ever to be achievable for the inflation component in debt. Hence, if the Committee believes that cash flow hedge accounting is not available, our recommendation would be for the Committee to recommend that the IASB reconsiders the guidance in IFRS 9 B6.3.13 to 15. Should you wish to discuss the contents of this letter with us, please contact Laure Guégan at [email protected] or on + 33 (0) 1 46 93 63 58. Yours faithfully


staff paper april 2021 (ifrs 9)

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